Grid Dynamics Holdings, Inc. (GDYN) Q3 2020 Earnings Call Transcript

Good day, ladies and gentlemen, and welcome to the Grid Dynamics Holdings, Inc. Third Quarter 2020 Earnings Conference Call. A question-and-answer session will follow the formal presentation. As a reminder, this conference call is being recorded. I would now like to turn the conference over to Ms. Lilly Chernova of Investor Relations. You may begin.

Good afternoon, and welcome to Grid Dynamics Third Quarter 2020 Earnings Conference Call. Before we begin, let me remind everyone that today's discussion will contain forward-looking statements based on our current assumptions, expectations, and beliefs, including our fourth quarter 2020 financial guidance, the growth of Grid Dynamics business, our objectives and business strategies, as well as other forward-looking statements. You can refer to the disclosure at the end of the company's earnings press release and Form 8-K filed with the SEC today for information about forward-looking statements that will be made on this call. All statements made today reflect our current expectations only, and we undertake no obligation to update any of them to reflect the events that will occur after this call. You can learn more about the specific risk factors that could cause our actual results to differ materially from today's discussion in the Risk Factors section of the company's Form 10-Q filed on August 6, 2020, and in subsequent periodic reports that the company filed with the SEC. Also, during this call, we will discuss certain non-GAAP measures of our performance. GAAP to non-GAAP financial reconciliations and supplemental financial information are provided in the earnings press release and the 8-K filed with the Securities and Exchange Commission. This call is also available via webcast. You can find all the information I have just described in the Investor Relations section of Grid Dynamics website. Joining us on the call today are CEO, Leonard Livschitz; and CFO, Anil Doradla. Following their prepared remarks, we will open the call to your questions. With that, let me turn the call over to Leonard.

Thank you, Lilly. Good afternoon, everyone, and thank you for joining us today. I'm excited to share the progress we have made since we spoke with you three months ago. Today, I will provide highlights of our third quarter results, share what we're witnessing across our business on the demand front and talk about the trends shaping our fourth quarter. In the third quarter, our revenue of $26.3 million grew 18% sequentially and was one of the highest quarter-over-quarter growth rates in the company's history. More importantly, the trends driving our third-quarter results, both from customer demand and on the delivery front, were very encouraging, and we're setting the stage for a favorable fourth quarter and 2021. Although there were many positive trends, I would like to highlight a few. First, in the third quarter, we witnessed a strong pickup in customer activities across the board as digital transformation initiatives took center stage. These trends will continue in the fourth quarter, and we anticipate the revenue run rate to approach the level we had at the end of 2019, with strong contributions from our top clients. Second, within our retail segment, we saw strong pickup from specialized e-commerce-friendly retailers. Furthermore, we see somewhat of an overhaul as new categories of retail customers emerge. Again, as we enter 2021, we will not rely on traditional retail as we succeed in diversifying our revenue composition across TMT, CPG, fintech, manufacturing, and other industries. Third, some of our larger customers are increasingly seeking to engage with our offshore locations. While the motivations are customer-specific, continued demand for cost efficiency, combined with greater acceptance of remote work, have influenced many customers toward increasing the use of Grid Dynamics offshore locations. Fourth, companies are focusing on improving efficiencies across their sales lifecycle and operations by leveraging data-driven solutions. Our customers demand Grid Dynamics expertise in data science, big data engineering, and artificial intelligence. Coming back to the third quarter, we witnessed growing demand for our expertise as customers steadily increased their investments in digital transformation. This was not specific to any one market but rather widespread across industry verticals. In each of the three months of the third quarter, our revenue grew sequentially, with September being the fourth consecutive month of growth. Most importantly, in October, we saw the same upward trend, instilling confidence in our Q4 outlook and momentum for a recovery to pre-COVID levels and beyond. On the profitability front, there was a strong pickup in our margins from the second quarter. This was driven by two key factors: the first was an increased utilization rate across the company, and the second was a greater mix of offshoring. While we expect these trends to continue providing tailwinds to our business in the fourth quarter, the reinstatement of compensation as well as strategic sales force hires may offset some of the gains. Anil will provide more color around the margin movements in the fourth quarter. Our non-retail business represented 77% of revenue and grew 10% on a sequential basis, and importantly, this part of the business has grown double digits sequentially in each of the third quarters of 2020. The continuous trends, even during the pandemic crisis, clearly validate the importance of digital transformation. In our retail segment, we witnessed strong sequential growth from the second quarter as our retail customers opened their stores and resumed operations. That said, the growth was not consistent across retail customers, with the majority of retailers still operating with smaller IT budgets for the remainder of 2020. While we anticipate a pickup in revenue in Q4, we do not expect to achieve pre-COVID levels of revenue in the retail business. During the quarter, we delivered some notable projects, including assisting and enhancing the revenue of a leading search technology company by integrating its search engine at several large enterprises in the United States as part of their partnership to improve online customer experience in product search and placement. We optimized a global CPG company's in-house cloud data platform, resulting in a 75% improvement in data processing latency and significant cost reductions associated with infrastructure and maintenance. Additionally, we built a marketing platform for a leading digital advertisement company using our expertise in data science and data engineering, which increased their ad conversion by 44%. At a U.S. retailer, we created a customized loyalty platform that replaced an existing platform that was expensive and inefficient, enhancing customer experience and satisfaction. In the current pandemic environment, consumers are demanding a robust digital online experience to shop for goods and services, demonstrating how COVID-19 has catalyzed digital transformation. Despite this time of uncertainty and uneven customer demand, we continue to perform well in acquiring new customers, particularly in our higher growth verticals. During this quarter, Grid Dynamics added five new logos through at least four significant players in the medical device technology space, home improvement sector, and a global financial technology payment platform. We believe these logos have the potential to become large customers over time. Additionally, we continue to progress on customer diversification. During the quarter, two of our top five clients were in the technology sector and one each in CPG, retail, and fintech. Our top clients for the quarter were Apple and Google. With that, let me turn the call over to Anil, who will discuss the third quarter results in more detail. Anil?

Thanks, Leonard. Good afternoon, everyone. Let me start by summarizing our third quarter 2020 results. Total revenue for the third quarter was $26.3 million, an increase of 18% sequentially and a decline of 16% year-over-year, exceeding our guidance range of $24.5 million to $26 million. Other than financial services, all segments grew over the second quarter, with strong quarter-over-quarter growth coming from CPG, manufacturing, retail, and the other segment. Technology, media, and telecom, commonly referred to as technology, was the largest vertical in the quarter. Our non-retail business, which represented 77% of revenues this quarter, was up 10% quarter-over-quarter and 47% year-over-year. Key highlights included our technology segment, which represented 48% of our revenues and grew 6% sequentially and 45% year-over-year. CPG and manufacturing represented 13% of our revenue and grew 36% sequentially and 146% year-over-year. Here are the details of the revenue mix. Revenue for the three months ended September 30, 2020, from our retail segment was 23% of our total revenue, a drop of 33 percentage points from the year-ago quarter. During the quarter, we witnessed a sequential pickup in revenues from this segment as most of the retailers started engaging with some of the rapidly growing e-commerce retailers. The technology segment accounted for 48% of total revenue, up from 28% of revenue in the year-ago quarter. Finance was 12% of revenue, up from 10% a year ago, and CPG and manufacturing represented 13%, up from 4% in the year-ago quarter. Finally, the other segment was 4% of revenue, up from 2% in the year-ago quarter. We exited the third quarter with 1,204 employees, down from the second quarter headcount of 1,237 and from 1,350 employees in the third quarter of 2019. The sequential decline was largely due to the effects of the restructuring program initiated a few quarters ago that spilled over into the early part of the third quarter. At the end of the third quarter 2020, our total U.S. headcount was 249 employees, or 21% of the company's total headcount, while our non-U.S. headcount, which we sometimes refer to as offshore, located in Central and Eastern Europe was 955 or 79%. Revenue from our top five and top ten customers accounted for 60% and 78% of revenue, respectively. During the same period a year ago, our top five and top ten customer concentrations were 67% and 85%, respectively. We exited the quarter with 42 paying customers, up from 35 in the third quarter of 2019 and up from 37 customers in the second quarter of 2020. As a reminder, we only count the revenue-generating customers in the quarter and do not include inactive customers. Relative to the second quarter, we added five new logos, with one in technology, one in retail, one in finance, and two in other segments. Moving to the income statement, our GAAP gross margin during the quarter was $11.2 million or 42.4%, down from $13.8 million or 44% in the three months ended September 2019. The key reason for the decline was a combination of lower revenues, increased stock-based compensation, and other costs. On a non-GAAP basis, our gross margin was 42.6%, down from 44.7% in the same year-ago period. The year-over-year decline of 210 basis points was due to a combination of lower revenues and other costs. On a sequential basis, our GAAP and non-GAAP gross margins increased by 490 basis points. The strong sequential movement in gross margin was driven by multiple factors, including an increase in company-wide utilization as revenue picked up in the third quarter, a greater share of offshore billable engineers as customers increasingly sought to work with our offshore locations, cost savings from lower levels of spending as restrictions continued to be in place, and the increase in the number of working days. Adjusted EBITDA during the quarter, excluding stock-based compensation, was $4.2 million or 16% of revenue, down from $7 million or 22% of revenue in the third quarter a year ago. The decline was mainly due to decreased revenues, combined with increased operating costs, such as public company costs. Our GAAP net income totaled a loss of $1.1 million, or a loss of $0.02 per diluted share based on 49.7 million shares compared to a GAAP net income of $4.5 million or $0.20 per diluted share based on 22.7 million shares in the year-ago quarter. On a non-GAAP basis, our net income was $2.5 million or $0.05 per diluted share based on 49.7 million shares compared to $5.1 million or $0.23 per diluted share based on 22.7 million shares. The decline in GAAP and non-GAAP income was due to a combination of reasons highlighted earlier, both on the gross margin and operating expense front. Our cash, cash equivalents, and short-term investments totaled $126.5 million, up from $123 million in the second quarter and $42 million as of December 31, 2019. The sequential increase in the current quarter was due to continued positive cash generation aided by aged accounts receivable payments from some of our higher-risk customers. The significant increase from the December 31, 2019 balance was primarily due to the successful merger between ChaSerg and Grid Dynamics on March 5, 2020. As you may recall, in the second quarter, we reserved a total of $0.8 million for the allowance of doubtful accounts. Over the past three months, we received payments from our high-risk customers and continue to engage with them to ensure they fulfill their payment obligations. Based on our latest review, we are lowering our reserves to $0.4 million to a final amount of $0.4 million. Coming to the Q4 guidance, we are providing revenue guidance for the fourth quarter and expect revenues to be in the range of $27.7 million to $28.7 million. That concludes our prepared remarks. Operator, please open the line for questions.

Our first question comes from Bryan Bergin with Cowen.

This is Zack Ajzenman in for Bryan. First one, could you maybe shed a little more color on the insights around sales force expansion and how we should think about the sales and marketing strategy moving forward?

This is Leonard. As we've acknowledged before, we continue to invest in expanding our sales force. We're looking to bring in senior talent and will provide more color on that as we progress. Right now, we're primarily focusing on geographical and industrial specialization as we continue to recruit senior leadership within the sales organization. Regarding marketing, as we transitioned into a remote virtual world, our focus has shifted to events, webinars, customer communication, etc. So on the marketing front, we have accelerated our communication efforts, while on the sales side, we are strengthening our sales organization.

Understood. And just a follow-up, there was a nice upside to the gross margin this quarter. It sounds like utilization was running at elevated levels. How should we think about utilization as things normalize and the plan to potentially increase billable staff going forward given the improved demand environment?

Sure. Yes. We had a roughly 490 basis points margin expansion, as discussed in our prepared comments. Our utilization levels increased after experiencing drops in Q2. As we go into Q4, from a modeling perspective, what I would suggest is that across our COGS and OpEx combined, we should see about a $2.5 million increase, with the breakup being roughly two-thirds, one-third between COGS and OpEx. This should lead our gross margins to hover around our target of 40%. Although we do have some tailwinds, there will be offsets due to some of our investments. Let me summarize by saying that the underlying health of the business and fundamentals are moving in the right direction.

Our next question comes from the line of Joseph Vafi with Canaccord.

Good results. Just a couple of questions. First, on the sequential increase in TMT this quarter. Could you parse that out, perhaps a bit of it being seasonal strength compared to share of wallet or expansions with customers and any particular items that you want to call out to get a clearer idea of growth with those customers in that vertical moving forward? And then I have a quick follow-up.

Sure. The high-level picture is straightforward. There is an increased amount of spending with Grid Dynamics by all major tech clients and newer clients we've acquired. I wouldn't classify it as seasonal. It may reflect expectations to invest more into digital due to the COVID situation, but many of the projects are long-planned term programs that were either not affected or accelerated. They are broad in nature, encompassing areas such as analytics, artificial intelligence, data processing, big data, marketing-related projects, and some partnerships for qualification. Overall, I see our capabilities continuing to expand in the future.

Great. That's helpful, Leonard. And then just a quick follow-up. To understand the underlying dynamics in the retail sector a bit more clearly, with more on-premise sales occurring this quarter with stores open, how do you foresee their business models evolving over time towards more e-commerce versus brick-and-mortar sales? Can we rely more on e-commerce moving forward, or do we need brick-and-mortar locations to bounce back significantly?

Sure. That’s a long question, so let me try to break it down. We’re noticing a trend where emerging projects and clients are becoming more e-commerce-driven and e-commerce-savvy. This applies to retail and extends into the CPG segment as some retail partners can’t promote their products aggressively, leading them to enhance their capabilities, which benefits Grid Dynamics in CPG. As for brick-and-mortar businesses, these companies are making fewer investments into physical footprints while becoming more dynamic in their product offerings. Large department stores continue to operate under lower IT budgets compared to pre-COVID times. Our two largest customers were Macy's and Kohl's, and our relationships are not what they were before COVID. So to summarize: we're seeing an acceleration in e-commerce overall, with smaller players being more active and allocating larger budgets for IT, while larger brick-and-mortar stores are investing less in expansion.

Our next question comes from the line of Maggie Nolan with William Blair.

I was pleased to see the new customer additions. Are you identifying any of these as having greater potential than the others, particularly in reaching certain milestones over a number of years? How substantial are some of these initial projects, and what is the plan for further collaboration with these customers?

Very good. Good to hear from you, Maggie. There are a couple of factors to consider. In my presentation, I mentioned that many of these new customers are large enterprises with significant potential for growth. We continue to execute our $2 million, $5 million, $10 million strategy as we extend past earlier engagements with clients. All of them are positioned more than $2 million, with a couple showing the potential to exceed $5 million and possibly $10 million. Initial engagements usually involve technology solutions and challenging tasks, which customers favor due to our technology, digital, and data services capabilities. As for the current engagements, they are transitioning from early-stage projects to significantly larger undertakings as we speak. Overall, the outlook is very favorable with promising enterprise clients.

Very good. And then on the cost side of things, we’ve heard a lot from companies this earnings cycle about managing costs during the pandemic, especially regarding the opportunity for structurally lower costs going forward. I know this situation is somewhat different for Grid since you have public company costs now, but is there an opportunity to think differently about the business and expenses in the coming quarters and years?

Yes. Thanks for your question, Maggie. As you'd expect, everyone is working from home, so we're experiencing reduced travel costs due to travel restrictions. In an IT services company, travel costs can be substantial, and we've seen those expenses run at roughly half of what they were a couple of quarters ago. For example, our travel expenses have significantly decreased as a percentage of revenue from Q1 to Q3, with the largest reduction seen in Q2 and a lesser reduction in Q3. While we're benefiting from this during our budgeting for 2021, some of these costs will likely return as restrictions ease. Our offices are distributed globally and we are reassessing costs while taking advantage of the current savings. Thus, while increases in revenue and public company costs will likely provide leverage for us, we must consider these moving parts.

Yes. I want to add to that. It's worth noting that as we expand our offshore hiring rapidly, there will be some associated costs, but the margin perspective looks very healthy. Furthermore, as we grow our teams, we benefit from raising utilization rates, allowing us to match supply and demand effectively. Although Anil mentioned in Q3 we had slightly lower headcount and engineering staff, we have since surpassed those numbers and are quickly returning to pre-COVID performance levels. While costs will rise, they will correspond to our expansion efforts.

One more. I understand if you don't have this number readily available, but do you know what the non-retail revenue was in Q4 of last year? I know you would not be able to provide the exact figure just yet.

If you give me a moment, I can look that up. So, for Q4 of last year, roughly 77% of our revenue was non-retail, which translates to about $17 million of our $31 million total revenue.

Our next question comes from the line of Mayank Tandon with Needham.

Great job on the quarter. I have a few questions regarding demand. Any early thoughts on 2021? I was just wondering if you could share some insights into the bookings momentum you've seen, especially in terms of backlog buildup? I know you don't provide these metrics, but qualitatively, what are the trends suggesting regarding sustainability of demand going into 2021? I'm trying to gauge when we might return to our normalized growth levels, around 20%-25%, which digital services companies are targeting once we move past these short-term pain points.

Thank you, Mayank. Let me take the first part, and I'm sure Anil will add some thoughts. First of all, as you know, we don't provide direct guidance for 2021 at this stage, but it doesn't mean we are unaware of trends. 2020 was quite an unusual year for us. We experienced significant growth in Q3, both in revenue and profitability, but we started from a low point. As an ambitious CEO, I seek substantial growth above pre-COVID levels, encompassing performance metrics, including profitability. We need to be proactive moving forward. I foresee that in terms of revenue, we should reach pre-COVID levels by the end of Q4. As for early 2021 bookings and new contracts, it's a bit premature to discuss in early November. In the best of times, clients discuss budgeting in late November or early December, so we’re still refining our approach. Overall, I'm optimistic based on our broad diversification strategy. Our turnaround was not just about clients returning to the budget but expanding our client base. While I see positive signals, let's wait until the next call for more detailed insights.

Absolutely. That's very helpful. I have a follow-up: How did revenue break down between any pricing increases if the demand environment shows improvement? How much can we boost utilization? I'm assuming hiring will be key to achieving normalized growth levels?

So, Mayank, I know that your question consists of two or three parts, so let me address them. Your first question was about the pricing environment. We haven't observed significant changes affecting pricing. There are no notable trends. Previously, we provided discounts earlier in the year, which are now reversing. Though our utilization is increasing, the pricing impact is neutral overall. Leonard, would you like to add anything?

Yes. The term normalization is relative. We are entering a more normalized state in terms of pricing and costs. I believe we can build a solid model going forward regarding revenue. I am carefully approaching headcount growth, seeking to invest in relevant skill sets. We have not slowed down our internship programs at Grid Dynamics. We're approaching demand with excellent capabilities, and we're expanding headcount. Additionally, we've invested in various intriguing R&D projects that are now becoming solutions for customer tests, particularly in the data side of the business, which will position us well from a pricing standpoint moving forward.

Got it. That's again very helpful. As a quick follow-up regarding M&A opportunities, given the stability of the business and the growth in your cash reserves, do you think it's time for some tuck-in M&A, either capability-driven or geographic, or is this solely about organic growth for now?

It's always relevant to consider deploying cash for M&A. We are actively evaluating some key opportunities, both geographically and within specific industry verticals, as well as specializations. That process is ongoing. However, it's premature to speak about specific amounts or timelines, as we have a pipeline of opportunities we are carefully analyzing. Due diligence is somewhat more complex during COVID, but we are confident in our prospects. We are focusing on the U.S., Europe, and several verticals simultaneously. Let’s remain patient, and we’ll provide updates when they are available.

Our next question comes from Tim Savageaux with Northland Capital Markets.

This is actually Stephen on for Tim. I was wondering if you could provide more detail about your expectations for the recovery in retail. Are we to expect a ramp-up into Q4, or should we be looking at the situation in the first half of 2021, or might recovery extend into the second half of 2021?

Stephen, can you hear me? I seem to have lost your question. Could you repeat it?

Let me jump in, I got his first part. Essentially, you're inquiring about the recovery of retail. I believe we already covered this in the previous Q&A, highlighting how more e-commerce-driven companies are performing well, while larger department store brick-and-mortar establishments are more uncertain. Time will tell in that regard. We've also noted the ongoing acceleration of CPG growth. I cannot provide clear visibility into a full recovery of large brick-and-mortar stores, so this will remain to be seen.

When discussing recovery, Leonard mentioned in his opening comments that we expect to exit the year running close to last year's levels. However, I want to stress that the company's composition will be a bit different in 2021. As I mentioned earlier, more than half of our revenues were driven by the retail sector a year ago. This quarter, that has dropped to about 23%. Therefore, as we go into the new year, our dependence on larger brick-and-mortar companies has diminished, and we can consider more opportunities with different customers and markets, particularly in the growth from non-retail sectors.

That concludes our Q&A session. Mr. Livschitz, I'll turn the call back over to you.

Thank you, everybody, for joining us on the call today. Our third quarter results were strong as we effectively executed our guidance, and I am very proud of our entire team for their persistent effort toward achieving our goals. Customers are steadily returning, demand is picking up, and we continue to diversify our business. The disruptions caused by COVID-19 early this year prompted us to act swiftly and decisively to manage uncertainties and capitalize on market opportunities. We enter the fourth quarter with elevated confidence, and we look forward to providing a business update in three months. Thank you all.

Thank you. That does conclude the conference call for today. We thank you all for your participation and ask that you please disconnect your lines.